An entity can choose to adopt an arm's length debt amount as its maximum allowable debt. It would generally do so only if its adjusted average debt is more than both its safe harbour debt amount and its worldwide gearing debt amount. Outward investors that are also foreign controlled cannot use the worldwide gearing debt amount.
The focus of the arm's length debt analysis is on the entity's Australian business and investments. The arm's length debt amount is determined by conducting an analysis with regard to certain factual assumptions and relevant factors. The factual assumptions include some conditions that actually exist during the income year and some conditions that replace what actually happened during that period.
Broadly, the assumptions are that:
- the entity's only commercial activities are those of its Australian business
- the entity's Australian business was independent of any guarantee, security or other support provided by any of its associates or by the use of the assets that are attributable to any overseas permanent establishments.
Certain factors must be taken into account when doing the analysis. These are outlined below. All the factors must be taken into account and must be considered in the context of the above assumptions. The factors should not be considered in isolation from each other. The weight given to each factor in the analysis of a particular entity may vary depending on the facts and circumstances of each case.
The factors are:
- the functions the entity performed, the assets used and the risks it assumed in relation to its Australian business throughout the year
- the terms and conditions of loans, such as interest rate, repayment amount and the duration of the loan the entity actually had in relation to its Australian business throughout the year
- the nature of, and title to, any of the entity's assets attributable to the Australian business that were available to the entity to provide as security for the loans of that business throughout the year
- the purpose of entering into the loan arrangements in relation to the Australian business throughout the year
- the entity's capacity to repay both the interest and principal components of the debt, in addition to all its other liabilities, in relation to its Australian business throughout the year
- the entity's profitability and the return on its capital in relation to the Australian business, whether during that year or at any other time
- the debt-to-equity ratio of the entity in relation to its Australian business, to each of the entity's associate entities that engage in commercial activities similar to the Australian business and each other entity that the entity has a direct or indirect interest
- commercial practices adopted by independent parties dealing with each other at arm's length in the industry in which the entity operated its Australian business throughout the year, whether in Australia or in comparable markets elsewhere
- the way in which the entity financed its foreign commercial activities throughout the year
- the general state of the Australian economy throughout the year
- all of the above factors that existed when the entity previously entered into a scheme that gave rise to an actual debt interest attributable to the Australian business that remained on issue throughout the year
- any other relevant factors that must be considered as set out in the regulations made for the purposes of the arm's length debt amount test.
If an entity is relying on an arm's length debt amount, it must keep records documenting the application of the factual assumptions and relevant factors.
These records must be prepared before the entity lodges its tax return.
Remember, if the entity has not appropriately taken into account the factual assumptions and the relevant factors to calculate the arm's length amount, we can substitute a different arm's length amount that we consider to better reflect those assumptions and relevant factors.
- Taxation Ruling TR 2020/4
- Practical Compliance Guideline PCG 2020/7
- section 820-105 of the ITAA 1997.
Once you have worked out the entity's arm's length debt amount, compare it to the entity's adjusted average debt.
If the entity's adjusted average debt is equal to or less than the arm's length debt amount, the entity is not disallowed any debt deductions under the thin capitalisation rules. You do not have to complete any more calculations.
However, if the entity's adjusted average debt is more than the arm's length debt amount, the safe harbour debt amount and the worldwide gearing debt amount, you must complete step 5.To check if you meet the requirements under thin capitalisation rules if you are a non-ADI general outward investor.